Forecasting the Equity Risk Premium: The Role of Technical Indicators

• Published in: Management science Vol. 60; no. 7; pp. 1772 - 1791
• Main Authors: Neely, Christopher J., Rapach, David E., Tu, Jun, Zhou, Guofu
• Format: Journal Article
• Language: English
• Published: Linthicum INFORMS 01.07.2014; Institute for Operations Research and the Management Sciences
• Subjects: Analysis; Arithmetic mean; Asset allocation; business cycle; Business cycles; Economic indicators; Economic recessions; Equity; Equity (Finance); equity risk premium predictability; Forecasting; Forecasting models; Forecasts; Forecasts and trends; Indicators; Investors; Macroeconomic modeling; macroeconomic variables; Macroeconomics; Management science; momentum; moving averages; out-of-sample forecasts; Risk; Risk exposure; Risk premiums; Securities markets; sentiment; Statistical forecasts; Studies; U.S.A; volume; United States; United States > US
• ISSN: 0025-1909; 1526-5501
• DOI: 10.1287/mnsc.2013.1838

Academic research relies extensively on macroeconomic variables to forecast the U.S. equity risk premium, with relatively little attention paid to the technical indicators widely employed by practitioners. Our paper fills this gap by comparing the predictive ability of technical indicators with that of macroeconomic variables. Technical indicators display statistically and economically significant in-sample and out-of-sample predictive power, matching or exceeding that of macroeconomic variables. Furthermore, technical indicators and macroeconomic variables provide complementary information over the business cycle: technical indicators better detect the typical decline in the equity risk premium near business-cycle peaks, whereas macroeconomic variables more readily pick up the typical rise in the equity risk premium near cyclical troughs. Consistent with this behavior, we show that combining information from both technical indicators and macroeconomic variables significantly improves equity risk premium forecasts versus using either type of information alone. Overall, the substantial countercyclical fluctuations in the equity risk premium appear well captured by the combined information in technical indicators and macroeconomic variables. Data, as supplemental material, are available at http://dx.doi.org/10.1287/mnsc.2013.1838 . This paper was accepted by Wei Jiang, finance.